Abstract:
The state of Digital Trading on the Internet is surveyed with the assistance
of case studies of high-profile service providers. These
providers use the Internet for delivery of trading instructions,
and IPO data, and some hope to build exchanges based on
Internet access. The efficiencies so far demonstrated
indicate dramatic structural change.

An alternative technical approach of digital certificate
trading is described, and lessons learnt in early trials are
explored.

It is proposed that the future financial system will be
built on open, direct access of all to the markets,
that trades will be costless and that settlement will
be immediate. This is based on the prediction that
digital certificate technology provides for this promise,
and will either supplant existing techniques, or force
alternates that perform at least as well.

Show where the existing
innovations have taken the digital trading world
by looking at
The State of the Art
.
Several case studies are used to concentrate on
the biggest lessons so far.

Describe the Internet trading trials of the author's
company, Systemics Ltd.
Experiences in Digital Trading
shows that this approach offers
a new structure to the industry,
and more dramatic savings for Digital Trading.

Using our most optimistic guesses
and the lessons from current work and cases,
an attempt is
made to map out what the
What the Future Holds
for the financial system.

In
Concluding Remarks
attention is focused back on more immediate implications:
how participants are going to be effected,
and what we can reliably say about future changes.

A lot of time and money has already been invested into trading
on the Internet. The industry, if it can be so labelled, is
well advanced in some segments, and
still in the early phases of experimentation and search for
workable models in others.

In this section, we look at what the Internet claims to be able to do.
We then look at what has been done so far.
The state of the art is best shown by three cases:

The simplest uses of the Internet are the distribution of information
that is currently dominated by the physical paper & postal methods.

The Web has an ability to present non-technical
users with enormous quantities of well ordered information,
and all at a marginal cost that is, to all intents and purposes, zero.
With a bit shoe-horning, it can be made to accept simple information.
Combined, this power that has made it
the second killer app of the Internet
[Email].

We can disseminate all non-critical information using a combination
of the Web and email, in both directions.
The following processes can be automated:

Financial Web sites, as Euromoney
says, are no longer little more than electronic advertisements
[Webb1].
As more familiarity with the scope of Internet communications
develop, institutions are beginning to experiment with:

Pricing Models and Portfolio Risk Analysis.

Portfolio Accounting.

Databases of Trading Information.

Inventory Level.

This list constitutes a major fraction of the activities
of the institutions. The conclusion that should be drawn here is
not that security and bandwidth problems abound, but that all of the
informational aspects of financial systems can, in theory,
be put onto the Internet.
The questions of when and how are technicalities,
if, as is claimed by the supporters, the Internet delivers vastly
improved economics for informational systems.

With the use of
SSL,
a protocol to protect browsing from hackers,
it is possible to securely request
identities and passwords,
and to achieve a high degree of confidence
that the user is an authorised person
[Treuhaft].
With sufficient information,
that user can instruct a Web-based service with
a similar level of confidence
as over the telephone or fax.

Once we achieve this level of confidence,
high value instructions can be issued, such
as trading and movement of funds.
This is the method used by many
brokers to accept trade instructions.

As one regulator says, this is not an exciting a development in and
of itself.
Fundamentally, the Web trade adds a new method to transmit the
order instruction to the broker; and alongside the telephone and
the fax, this represents simply a new way to cut costs on mundane
information transmission
[Wallman].

Regardless of one's skepticism for the apparent simplicity of the
new model, cost savings have been dramatic.
Brokers
such as Datek Online are now
offering trades for $9.99.
[Datek].
Cost reductions of this nature - an order of magnitude less
than full service brokers -
can signal dramatic change in the industry by themselves.

If net broking is successful, and generates sufficient
interest in net trading as a normal investor activity,
the next step
might be the possibility of crossing orders within the broker.

The rational for an Internet Stock Exchange is apparent to those
outside the club, at least. Consider this list by Duncan Goldie-Scot of
the Virtual Investor
[Goldie-Scot1]:

existing exchanges are parochial - the Internet is global

regulatory barriers rob small and cross-border IPOs of
much of their market

existing markets are too expensive - lacklustre competition
makes for lacklustre service, and pricing that only pleases
the incumbents.

lop-sided information flows are common - between
professional analysts and ordinary investors,
between so-called sophisticated investors and ordinary investors,

they are simply inefficient at raising capital for the small
entrepreneur.

Indeed, a survey conducted by Alan Majer asked whether an Internet
stock exchange would have any advantage, and 88% felt it would,
with 12% undecided
[Majer].
With this heady mixture of opportunities,
the idea of an Internet exchange bears serious consideration.

Any one of the suggested advantages of
Internet brokering represents good news for the
individual, as they signal price reductions in an overweight
industry.

In contrast to the view that a net broker simply bypasses
the telephone,
it is when the effect of all of the above innovations are together
in one place that the full impact occurs.
At this stage,
the reader should jump on to the Web and go to
http://www.etrade.com/visitor/demo/
to see the
E*TRADE demo.
Bear in mind that this is a demo of working systems for the
customer of services, not a prototype for the venture capitalist.

The above demo and further readings on E*TRADE's site
allow us to make some general comments:

You can put all of the power of any number of screens from
Reuters, Bloombergs, etc, all onto the Web. And thence to
the individual trader.

The only necessary non-Internet access by the user is to send
in the payment with the
application, and to request mailing of payments.

One Web site covers an enourmous user base.
From a variety of sources, E*TRADE has
145,000 active accounts
[DowJones],
is doing 20,000 trades per day
[Schmerken],
and is moving 7.8 million shares daily (that's roughly 1.5% of NYSE)
[Byron].

All of the above is concerned with the secondary market - the
market for shares already traded on an exchange.
The possibilities
of using the Internet as a primary market for new issues
was not really predicted until
The Spring Street Brewery
actually achieved it by using a combination of Internet marketing
and information distribution, advertising on the product, and
new regulations on small Initial Public Offerings.

The story starts at Christmas of 1992, when Andrew Klein quit his job as
a lawyer with Manhattan law firm Cravath, Swaine & Moore
in order to start a microbrewery that
produced Belgian Wit beer
[Wit7].

In the US
Securities Act of 1993,
reforms permitted non-public companies to sell up to five million
in company equity direct to the public
[Boyce].
Whilst not evidently successful
at the time, Klein understood in 1995
that combined with product marketing
and the spread and cost-effectiveness of the Internet,
he could reach a large enough base of small
investors to float his company, effectively on Internet.

Klein prepared the formal documents of an IPO to float shares
in The Spring Street Brewery in the normal way: by submitting
documents to the
Securities and Exchange Commission
and state regulators.
However, when it came to marketing his issue,
the stock was advertised on the net and on
the product, his prospectus was downloadable,
and email was used to communicate with the interested investors.
In the net-surfing beer-drinking investor community
around Manhattan, ready demand for an innovative launch was found.

The float was launched in February of 1996,
and the company
raised $1.6 million by selling 844,581 shares to 3,500
individuals at $1.85 each
[Wit6].

The company also built a simple bulletin-board style of
Web page where investors could express interest in buying
or selling.
It is not known what the SEC
originally thought of this move.
However, they very quickly hit Klein with an eleven lawyer
conference call
[Zgodzinksi],
and he agreed to "voluntarily suspend Wit-Trade" pending further
discussions.

The SEC is a great advocate of innovation, and in this case,
after 3 weeks of deliberations, a preliminary letter was issued
allowing trading to continue with a number of changes, the chief
of which was the outsourcing of the settlement to a registered broker
[Boyce].

Let's summarize the salient points of the floatation:

Klein did the floatation himself.

The stock was advertised on his own product, which
was a widely marketed, popular consumer product.

Significant savings were made in Internet delivery of documents
as well as advertising on the Web.

A significant hype premium was placed on his
stock, with some 2,000 news stories and a "What's cool"
listing on Netscape's site
[Bloom].

A simple Web bulletin board enabled stock holders to
post expressions of interest and prices for trading of stock.

Klein did his own
filings, but it is suggested that this was a unique desire of
his own, rather than a cold-hearted economically-efficient task.
Also, it should be born in mind that Klein
is an investment lawyer and MBA by training,
with previous experience in Regulation A listings.

Since that first offering, there have been many other
offerings.
In most of the similar DPO cases
to date, the activity has been led
by experienced legal and financial people
helping with a small, locally quoted stock
[DPO-Council][Investor Guide];

A major amount of work was incurred in going through the SEC
formal procedure: it is appropriate to recognise that the DPO process
is cheaper, but does not appear significantly
less lengthy than conventional IPOs.
In time, this should reduce,
due perhaps to computer software such as
CapScape
that automate the preparation of SEC documents
[Borrow_et_al],
and perhaps to further efforts by regulators to align
the paper-work burden with the size of the offering.

Another innovation took much of the credit. Putting a bulletin
board style of trading board on the Web was quite an achievement
for a brewer of beers or an investment lawyer,
but it is not anything beyond the average
Internet Web specialist software house. Having shown that this
is now possible, this can now be a competitive offering by
brokers, advisers and the like.

However, the major effect of the flotation
was to highlight that it was
something that could have been offered as a service by conventional
investment banks, but wasn't.
Realistically, we can conclude that this
is a new segment of financial advice, blessed
with a new name, the Direct Public Offering (and new acronym, DPO).

There is now a developing
DPO advisor segment to fill that gap, and renewed interest
by investment banks and brokers in this area, although it remains
to be seen which supplier can best provide a model for future DPOs.
The analysis of the SEC supports this:
In recognising that the process had simplified,
but not removed, the interface to the financial system,
they insisted that settlement be via
some other firm (e.g., a broker).

None of this is to degenerate the achievement of the floatation.
It required breadth of imagination to combine the aspects, and
enourmous perseverance, and Klein has been justly lauded by the
press and venture capitalists alike.

Klein's achievement is thus levelling the playing field
significantly; as advocates of the perfect market
should note, the cost of a floatation has been extended downwards
by an order of magnitude, from a floor of, say, $500,000 to a potential
lowest fees outgoings of $50,000
[Borrow_et_al2],
[Mamis].

What Klein did next is even more interesting.
In the fallout from the
hype and the 500 desperate phone calls seeking advice
[Zgodzinksi],
at some stage the demand for this sort of service struck home.
Klein had discovered an untapped segment of the market for financial services,
so he launched a financial services firm called
Wit Capital Corp.

The original plan was to set up a company
and offer the Internet floatation services as experience with Spring Street,
coupled with an array of other appropriate financial services.
From the notion of offering the Internet IPO as a service,
and the obvious economies of scale wrought by the bulletin board
market for own stock, the idea of setting up a complete Internet
stock exchange is an obvious next step.

By posting the bids and offers, and arranging for some order matching
software to match, or cross, the orders, it remains to just issue
instructions to settle the payment. Settlement of a trade is
a relatively humble task, and one that is simple enough when
both parties hold settlement accounts co-located with the trade
(and a provided service when not).

Having solved the technical issues, at least on paper,
we can see that the marketing game becomes
one of acquiring lots of user accounts. This then feeds into
demand for more IPOs, which enables the building of a market
place or stock exchange.

As a plan, it worked well enough for Wit Capital to acquire lots of
capital
[Wit1].
In tackling the challenge of building the world's first Internet investment
bank and stock exchange, Wit Capital have done the following
[Wit News][Duffy]:

Partnered with a Web and marketing house to gain access
to Internet technology and marketing.

Acquired stock exchange technology from the team that worked
with the Chicago and New York stock exchanges.

Boosted the board with finance experience.

Acquired brokering technology from brokerage software firms.

Signed up a deal with a settlement house.

Applied to the NASD for a license.

And so Wit Capital have assembled all the pieces to build their own financial
system of lenders, exchange and issuers. Or have they?

This plan is flawed, as evidenced by apparently slow progress of a
decade of Internet time
[I-years]
since inception to the launching of
their first service (Internet brokering to the markets)
[WitOpen].
Why? It comes down to these factors:

User base.

Wit Capital's efforts to register users in
advance of having something to sell them is
insufficient
[Goldie-Scot2].
Doing your own DPO is very different to selling DPOs as a service.
And being lauded by the press and financial community for
having discovered a new segment is not the same as having a
client base of either borrowers or lenders within that segment.

Lack of Uniqueness.

Wit Capital are not unique in wanting to
build a user base of lenders and
a reputation for pushing out DPOs.
As well as half a dozen direct copies
(ensuring some useful diversity)
there is no reason why any investment bank
or brokerage in Wall Street or anywhere
else can't copy their plans.

Worse, if Wit Capital succeed in even a small way,
this represents a proven, high-exposure,
model for large players, with client bases,
to copy and
migrate themselves into the new Internet financial system.

Breadth of activity.

The breadth of the challenge is too extensive.
By attempting to create an investment bank, a brokerage, and
a stock exchange, Wit Capital is taking on nearly the whole industry.
It is not so much the arrogance that is at issue here, but
the number of regulators and the size of the systems that
they now have to cope with. As each different aspect comes
into play, a new group of specialists emerges, and a new set
of lawyers calls in on the conference call.

Wrong Target.

Picking on the exchange is exciting from a
journalistic point of view, but ultimately illusory.

The purpose of a stock exchange, as evidenced by its structure,
is to allow
a cartel of brokers (the seats) to monopolise the
activity and force trades to pass through them. Over time,
the stock exchanges have begrudgingly become reasonably competitive
due to tight control by their owners, changes in rules, or
simple competition with other exchanges.
In contrast, the brokerages have grown fat off the success of
the cartel arrangement.

Notwithstanding the apparently low-valued profitability of
exchanges, indeed, it would
seem that this sector is somewhat crowded with the SEC finding
in excess of 140 alternative matching markets
operated by brokerages and other operations.
[SEC].

Further, stock exchanges need to be big in
order to provide liquidity, and generally only
a few of them make the grade. Klein recognises this, by saying
"This is not something we're going to try to do on a small scale,"
[Wells],
but simply recognising the scale of the challenge does not make
it strategically viable.

Beat Them Then Join Them.

Any start-up gets one chance at launching a surprise attack.
Klein used up his
when he set up the Wit-Trade bulletin board for trading shares.
As well as earning him the respect of the SEC for the innovation,
it has also earned him permanent oversight by the regulator and the
rest of the financial community.

In other aspects, such as the buy-out of the programming team
responsible for two exchanges, and the board being
stacked with financial members, Wit Capital has joined the community.
In fact, it looks as if an external player
has used takeovers and financial weight to muscle into the
industry, so rather than innovation, conformance is a more
likely strategy.

In contrast,
E*TRADE took on the brokerages: a part of the industry where
small and large players compete, so a small player can
try something new and grow unmolested.
It's also the part that had the most fat, not the least,
earning E*TRADE significant marginal difference in fees.

Further, online brokers such as E*TRADE and
Charles Schwab's
e.Schwab
are far better positioned to move into
the DPO and exchange business: with both the
user base and the pass-through trading systems
in place, the addition of new stock marketing
and internal crossing of orders is far less daunting
[Goldie-Scot2].

This activity is already occuring, with both E*TRADE
and e.Schwab
signalling their desire to join the distribution lists of
large IPOs
[E*TRADE1].
At the Internet exchange level, the SEC
has issued a request for comment
on a number of issues relating to the regulation of what
it calls the
'alternative matching markets.'

Euromoney cautiously suggests that
"perhaps even real-time trading" is to come
[Webb1].
This section describes experiences in real time digital trading
conducted by the small startup company of the author, Systemics Ltd.
It remains, as far as we are aware, the first and only
digital certificate trading system in existance.

Before describing our experiences, some background will help to
set the context of Systemics' view of the world.

What is a modern financial system? Delving deeply into this
question seems rather difficult,
as latter day examples are more complex than many, including those
at Systemics, can cope with, and the details quickly slide into mundanity.

Notwithstanding, there appear to be some common elements
in all financial systems, whether that of Amsterdam in the
first years of financing voyages to the new territories
or the International markets of today:

a medium of exchange, a.k.a. a payment system, or more simply, money

a means of transforming lending into fungible instruments
(debt and equity as certificates or book-entry systems)

a place for trading financial instruments
(exchanging money for loans)

a system of settlement to complete trades

many borrowers and many lenders

We could also mention more sophisticated additions such
as reputation, regulation, and intermediaries.
However, these are not considered here.

Astute historians will also recall that
in early systems there was no distinct settlement, as all
instruments took the form of paper certificates carried
and presented at the market place. This method suffered
difficulties when the invention of the telegraph allowed
instructions to outstrip paper delivery, thus causing
the separation of trading into instruction followed by
settlement.

Let us now assume that the
system of trading, as perceived by the external trader,
is made of core structure of three components,

the exchange,

the settlement or clearing house, and

the broker,

Now, a standard analysis of the cost components
within the price of a trade passed onto
the trader by the broker reveals that there are
two major components, and one minor:

The fee for a trade on stock exchange is quite low,
in the order of $2
[Fees1].

The fee for a settlement from the clearing houses is
in the order of $10 to $30, plus interest on debits
[Morgenson].

The fee for a broker trade is anywhere from $10 to over $100,
stretching from a Web broker such as Datek to a full service broker.
[Fees2].

The trade itself, as crossed by the exchange,
is simply not an attractive
target. In contrast,
the broker component and the clearance component are both
attractive in terms of the costs locked up in the processes
[Fees3].

This can be seen from a cursory examination of the processes:
a trade is only briefly in the exchange before being passed
over to the settlement process. No money or stock ever
enters a modern exchange, and the pure exchange takes on no
great risk (as counterparty substitution is generally conducted
by the clearing house). A trade passing through an exchange is a far
less complex process than the trade passing through the settlement house.

In construction of the Systemics' view of the Geodesic
Financial System
[Hettinga1],
the technology of digital certificates
was employed to develop digital financial instruments
that could settle immediately. This enabled the trade
instruction from a trader to a market to include the
instruments themselves, and resulted in the re-combination
of the trading process into one, atomic action.

The normal approach of digital trading
has been to speed up the process of issuing the
instruction, and look to other informational process
for secondary savings.
In contrast,
the approach of Systemics was to
eliminate the settlement process as an expensive component
of the trade.
This approach reverses the separation of
settlement and instruction that began when the the invention
of the telegraph allowed instructions to move faster than
paper certificates.

Systemics operated an "internal" market in digital certificate bonds
that were distributed amongst investors in the company.
This represented a trial or prototype to test the concepts
and operation of software. It was also integrated into a
straight retail system, in that the payment system was the same
[Howland].

The system consisted of Issuers of digital certificates and a
market for trading them. Digital certificates were issued
that represented several currencies and various debt instruments.
The value trial was conducted over a period of a year with
$10 zero-coupon bonds traded against a US dollars currency.

The following sections tries to
draw general lessons from the experiences.

The objective of the Exchange was to usher in a new era of micro-trading
in the Geodesic Financial System, based on the
purported savings of digital certificate trading
in eliminating the settlement process.

The system design was intended to work well at small numbers,
as eliminating costs meant that smaller trades than previously
envisaged were made possible.
This resulted in a number of effects:

The dollar currency sliced down to tenths of cents
(a.k.a. mils).
As a micro payments system, it worked well, but in reality nobody
was interested.
Once traders and (traditional) retailers
had gone to the trouble of hooking
up the system to do any transactions,
they were simply not interested
in 1000 trades that earned them $10 in revenues.

For the prices of trades,
we chose to use decimal pricing and consequently found a number
of rounding errors creeping into the system. As the essence
of the systems design was to avoid any possibility of loss, the
market always won the 'salami slice' by ensuring that rounding
errors were in its favour.

This came under challenge when we started receiving international
support calls from irate investors who had lost fractions of mils
(i.e., less than 0.05 of a cent). In retrospect, it would have
been more profitable to award any salami to any investor who owns
a calculator.

Digital Certificates Trading is cheap. Calculations on the
cost of each trade at the Exchange came in at from a cent to a dollar,
depending on turnover and how the variable costs were split up.

In fact it was so cheap that it could be ignored, until a support
call arrived. As support is an event that generates costs in the
hundreds of dollars, each support call wipes out the
potential profits for many thousands of other trades.

In effect, the limiting cost of the transaction was support,
and the conclusion to be drawn is that digital certificate trading
will be as cheap as the support can make it. We have a number
of models to reduce support, but it is question of more experimentation
whether these costs can reach sub-dollar levels and enable true
micro-trading
[support].

Digital certificate trading is an innovatory technique, but this
gives it no special dispensation in being reliable. In contrast,
it has to be more reliable than normal trading, due to the
support and security aspects of the design.

The first implementation was unreliable, in that, theoretical
failure modes existed that had severe support implications.
This unreliability proved
unsustainable in the long run,
and had to be replaced with newer versions of
protocols and servers that are 100% reliable.

In retrospect, this was a necessary step, and
anecdotal evidence suggests
that this experience was incurred by other
developers of similar Internet payment systems.

It was impossible to appreciate the view without having first taken
the journey. Only at the end of the first trading month was it
possible to sit back and map out the terrain covered: hardware,
programming, distribution, support, programming, finances, and
to then develop robust systems for the future.

How many disciplines are required to build a financial system?
These are the ones that we identified:

Accountancy and Auditing.

Programming.

Systems Architecture.

Cryptography.

Economics.

Internet and Security.

Finance and Banking.

Risk.

Marketing and Distribution.

Central Banking.

A cursory examination of any financial system confirms this,
and perhaps if such forward planning had been conducted,
the team would have been convinced ahead
of time to try another project.
As it was, team members made do by picking up the disciplines as required;
future startups are encouraged to put together multidisciplinary team
in advance.

As a technical issue, it was shown that it was possible for
one team or group or company to be able to run all the components.
As mentioned above,
there was a strain on the number of disciplines required, but once the
software was written and the procedures were in place, economies
of scope helped to make it possible to build a financial system
in a box
[Hardware].

Whilst achievable and achieved, the one-stop shop
was not necessarily the most appropriate
strategy for a small team to aim for. It became clear that even highly
trusting partners would balk at placing large sums into the hands
of programmers, no matter how many financial acronyms were mentioned.

As a principle, a financial system spreads responsibilities
amongst different parties, with different specialisations for
dispute resolution (the courts), escrow (the banks), operations
(the programmers), and trading (the markets)
[Hettinga2].

Spreading the responsibilities becomes efficient once the complexity
of the system is increased such that it is no longer transparent
to the average player. Rather than each player being required to
learn all aspects of how to trace and resolve problems, a player
learns the half-dozen major blocks, and how each block interacts
with the others to form a reliable, functioning system.

As it turns out, the point at which these efficiencies develop
occurs very quickly. Indeed, for Systemics' markets,
this occurred about the same time as interesting transactions were being
demonstrated.

The separation of responsibilities can then
be proposed as a more general rule, which is a useful
learning result of the experiences, but possibly
an obvious fact to the reader.
Unfortunately, this leaves us with the
future task of needing to develop a
system of cooperating institutions,
which has become perhaps
a greater stumbling block than developing
the software in the first place.

In contrast to the need to separate out responsibilities,
it was found that the distinction between money and
financial instruments was largely artificial, once
placed in a technical context.

An early assumption, mirrored by the current set of technologies,
was that money (or payment systems)
was distinct to financial applications.
Systemics' early plans were to espouse the
crowded field of electronic commerce,
and concentrate on digital trading.
For that reason,
systems were designed to allow traders to integrate the
money of other payment systems with the stocks and bonds
managed by our software.

In one sense the application of financial cryptographic techniques
to digital certificate trading is simply
an innovation that happens to use a lot of cash.
Once early prototypes were up and working,
however, it
was found that there is far more in similarity than
there ever was in difference between cash and instruments.

By issuing cash as
a financial instrument,
and by making some minor changes to
reflect this versatility,
a major component was removed from the system
(resulting in significant savings at all stages of the chain).

Furthermore,
we found that the system of digital trading was unified in a way
that opened up new possibilities: Systemics found itself in the
electronic commerce business, as well as in loyalty systems
and casinos.

We found that
cash is simply a financial instrument of a particular flavour.
Internet payment systems are thus
simply financial instrument management tools
that have only
been applied to retail-like sales transactions.
In contrast the financial system is a giant holistic network
of transactions and relationships, and payment systems should
reflect the conceptual basis of financial transactions,
not the underlying assumptions of the designers.

Gary Hamel and C.K. Prahalad suggest that we should search for major
discontinuities, and imagine world where these come to pass
[Hamel & Prahalad].

The major discontinuities are:

The Internet:
free and open access by all individuals to information and activity.

Globalisation and Regionalisation:
the shift away from national economies to
regional blocs within a global trading environment.

Financial Cryptography:
the development of a series of techniques
that allow secure electronic transactions over
insecure networks such as the Internet.

Let's imagine a future where digital trading is the norm.
A trade costs nothing, it takes no time to settle, and it is secure.
Anybody can trade,
all have direct access to the market with no intermediaries, just
like all surfers have access to the Web page, all businesses use
email.

Actually, to be fair, we have already shown that this is all technically
possible, so it is not really stretching us as
Hamel and Prahalad suggest.
But it is good enough for the current exercise,
as deployment is not a proven affair.

Further, it is not the first time that something like this has
happened. To see how trading used to be free, with universal access,
and immediate settlement, we need to go back several hundred years
to the earliest stock exchanges:

"
Historically, stock exchanges were open to all buyers and
sellers, and exchanges (like the Paris Bourse) were built at public
expense. The market was wide open. In New York, the colonial
capitalists gathered under the big buttonwood tree down by the
"wall" and traded stock in new ventures.
"
[Zgodzinksi].

Traders stood
around with portfolios of notes representing shares in trading ventures.
To trade, you simply had to be there. The trade was between the
buyer and seller, and settlement was generally immediate: cash for
certificate. Reliability was good, at least in good weather.
Security relied on a measure of trust and paid security,
much the same as now.

Of course, to see this in the current context we have had to assume
away much of the detail, such as distance.
Security relied very much on gentlemanly behaviour.
Costs were low, but one still had to hire a boy to carry
the portfolio of certificates. And there was the ever-present
danger of succumbing to natural monopoly pressures:

"
In May of 1792, the
exchange was formally opened with 24 brokers joining forces. All
buying and selling had to be done through one of these intermediaries.
For almost 200 years ....
this price fixing effectively had thwarted competition
between the members of this exclusive club.
"
[Zgodzinksi].

Without the ability to control trades, large centralised institutions
such as the London and New York exchanges are not workable structures.

However, liquidity is still required,
so large somethings are still on
the planning list.
What is left is a global market of individual stock holders
that is organised according to a set of protocols.
The current day model would be NASDAQ,
where the market is a collection of screens showing
market makers interested in quoting prices on stock.

How farfetched is this?
The Web already matches this organisation,
as the Web is simply
a collection of links that point to currently interesting places.

The Internet has already shown that a community of
disparate, far-flung technocrats can come together
in a mesh of coordination that defies understanding
in the conventional world of commercialism or state intervention.
Building the Geodesic Financial System might simply be a matter
of writing the RFCs
[IETF].

Money is mostly made on value added services,
but to add value a brokerage or a clearing house
must have something to add to.
Stripped of the trade, brokerages will
search for the only other link into the users pocket: the software.
Likewise, clearing houses that have been stripped of the
settlement will be competing for the same software.

Trader software is highly sophisticated and costly.
Users will be
searching for a painless way to get access to good software that manages
their trading activities. One-off purchasing is prohibitively clumsy,
and not valid in the intensively competitive world of trading. Freeware
solutions will do the basics, but give no help on decision making,
and provide support of a variable nature.

Brokers will evolve into services that provide the software,
and in the final analysis will become software firms:
both as authors
of trading software and as operators of networking installations.
Likewise,
as the clearing
and settlement functions are eliminated,
firms specialising
in the back-office process will also migrate to the same segment.

On this foundation, many new software operations
will attempt to sell added services such as markets,
issuance of financial instruments and funds.
But they will face an intensely competitive market where
any small player can conduct all of these operations
by simply downloading the basic protocol components of the
software and running it.

Investment banks will still have a role in IPOs, but the role
will be much more of a technical one, with the provision
of financial instrument issuance as a central plank.

Small brokers as intermediaries will disappear,
to be replaced by
funds management selling pure knowledge wrapped up into
specialised financial instruments.
The economies of scale in Internet brokering are much higher,
due to the complexity of trading software, than they ever
were with current day brokering.
Many brokers will not be able
to maintain their customer base whilst
meeting the demanding software investment.

Again this is not farfetched, as much of the movement is already
being seen: information providers such as Reuters and clearing
houses such as Bear, Sterns & Co, are now competing to provide
the software and operations for small brokers
[Schmerken].

In the Internet market, protection of the investor raises difficult
questions
[Lee]:

Which investors is a state regulator to protect, and from whom?

Is it neccessary to protect foreign investors from local crooks, or
locals from the foreigners?

How does jurisdiction get determined
in the first place?

Is there a distinction between Internet information
and a prospectus?

How can the regulator see the information passed
along private channels in the first place?

In a world where an investor can be an anonymous and stateless
netizen, where private access to channels is the norm,
where all rules are bent for rich foreigners,
and poor locals get a better deal by emailing another country,
it is difficult to imagine a strong investor protection scenario
on the Internet.

The answer is individual responsibility and education:
all investors are promoted to what the SEC calls sophisticated
investors and are thus considered responsible for themselves
by their very entry into the system. Then, the role of the investor
protection agency migrates to include:

Providing general education on trading.

Promoting minimum standards for disclosure.

Selling certification on a voluntary basis.

Providing a central point for fraud watch.

As institutions are regulated primarily for investor protection,
then a world of responsible investors limits useful control of the
institution as well.
This transformation has already happened to a large extent in the
banking world. Many central banks use their powers to audit the
procedures of the banks, but refrained from directing a bank to do
things in an approved way; their role is one of parental guidance from
the privileged position of sharing the secrets of all the
opponents. Likewise, it has been recognised for some time that
rescuing failed banks is self-defeating.

Even the above role by regulators is likely to be a temporary way station,
as there are obvious similarities between this
set of activities and the activities carried out by companies
such as
Dun & Bradstreet
and
Standard & Poor's
.

In the absence of some formal indication of security, how is any
individual supposed to know who is reliable? Reputation will
be a prized asset, raising the marketing component in any
intermediary's budget.
For example, E*TRADE spends about a quarter of its revenues on marketing
[E*TRADE2]

Rating services will become more prevalent,
and more normally consulted for all reputational purposes.

In a complex international situation, how do you settle disputes,
once reputation (or the threat to one's good reputation) has failed
to resolve them?

If the participants have agreed to draw contracts in a given jurisdiction,
then there is a potential to resolve disputes in front of the courts in
that place. However, this is likely to be extremely expensive, if we
assume that some or all of the parties are not actually based in that
place.

A more likely occurrence is the evolution of private law services such
as arbitration. These services already exist for some disputes, and
can probably migrate to full Internet dispute resolution far faster
than any legal system
[Kohn].
These services are likely to be drawn from accountancy
and law firms or arbitration associations such as the
American Arbitration Association.

The above future is one based on predictions of an eventual
economic structure, and is of course no more than a sum of predictions.
Whilst it is not possible to have a lot of confidence in predictions
about the eventual structure of the GFS, it is possible to
look more reliably at the next few years.

These conclusions attempt to draw out the predictions,
in the opinion of the author, that will indeed come to pass.

It might be thought that the innovations discussed
in this paper
represent welcome
efficiency boosts for an industry used to
only marginally improving service
year by year.
That is true, but only hints at the structural
change that will sweep through the industry over the next few years.

These changes include:

Access to markets will be primarily over the Internet.
The retail battle is won
[Brooks],
the primary distribution battle is looming
[Goldie-Scot2]
and the institutional market will inevitably face a fight
[Webb2]

Retail trading is a commoditised business with individuals
getting direct access to the markets on the same basis as
institutions, as well as all informational advantages as well.

With commoditisation comes the waxing of the IT and marketing stars,
and the waning of the financial and legal skills.

Economies of scale are rapidly climbing, meaning both that large
operations will be the norm, and large investments will be needed
to survive in the industry.
Pressure to invest will will squeeze out small brokers,
and will push larger brokers and clearance houses
into each other's arms, resulting in the convergance of
these two segments into one.

As larger operations become the norm, the distinction between the
liquidity available at the exchange and the liquidity available
within one operation will diminish. The future of exchanges is
also threatened by the more aggressive competition
of a many-to-many network
of traders accessing over public systems such as the Internet
[Warner]

Will the future consist of a costless transaction base, a truly open
market for trading, and a borderless economy that allows all equal access?

It is quite clear that the possibility exists;
it has been demonstrated, and it is thought to be theoretically sound.
For the moment, there are some technical, structural, and commercial issues
that prevent widespread deployment, however
entrepreneurs are working around the world to eliminate these issues.

If we assume that entrepreneurs could make
this world a reality, and due to the nature of the cost advantage
of digital certificate trading, it would be expected that only an
equally costless and equally open alternative would succeed.

Then, if not reality, the digital certificate model is a benchmark.
If the trading systems of any institution or company, or the economy
of any nation-state or trading region are not improving against the
digital certificate benchmark, then they can expect to be bypassed.

So the challenge remains the same: business and political leaders
everywhere should be preparing their charges for this world, whether
or not they subscribe to the precise mechanics of how it is accomplished.

This paper is rather US-centric, and this is a simple reflection
of the US leadership in digital trading.
Indeed, the US is so
far ahead that players in other
countries have little need to think,
they can simply copy the best from the US.

What is perhaps more concerning is that there is little hope that
non-US markets can catch up at this late stage.
The worse case might be for national markets to suffer an
Americanisation over the next decade, as the far better trading
opportunities available on the US markets
pull investors in,
and companies follow looking for liquidity.

We have seen how usage of the Internet to improve the efficiency
of the Financial System can deliver great gains. By using the new medium
for information dissemination, transaction instructions, and as a basis
for the marketing of lesser capitalised firms, we can eliminate many of
the warts of the existing system. The result is more than a face-lift,
it represents savings of an order of magnitude that portend dramatic
structural change.

In contrast we have also shown an alternate world, a new financial system
that will arise where the entire process
can take place on the Internet.
This promises transaction costs further orders of magnitude
lower than the
existing system, even in its new, Internet-enhanced, mode.

The nature of the competition between the two can be predicted, although
precise details will elude. It is the existing infrastructure against
the the sweeping digital winds of change. The victors will be those
corporations that with the one foot stand firm and defend the institutions
that have endured for so long, but with the other foot take their place in
the new world with experimental gusto.

Datek
One such brokerage is
Datek Online.
On their Web site,
trades were offered for $9.99 from 100 to 5000 shares,
including free real time quotes from the major US markets.
By the time you are reading this, there may very well be
a cheaper deal.
Back.

Fees1 LSX
recently
cut prices
(perhaps due to competition with
Tradepoint)
A £50k trade now costs £2.35 (outside order book)
or £3.00 (new order book), with sliding charges
down to a minimum of £0.25.

In contrast to the author's proposition,
Bolsa de Madrid
charges
nothing
for less than 5000 pesetas (about £20) ? and thereafter up to 2250 (about £8)
for 50 million pesetas (£250k).
However, settlement fees range from only 15 to 250 pesetas (about £1).
Could this be the result of the monopoly position by SLC, and fee
sharing being a centralised decision?

Fees3
The broker and clearing components are obviously
coming down very quickly. The historical
difference is disappearing as Web brokers put
downward pressure on the clearing houses to match
the deals, and the exchange may become an important
element in the future.
Thus, the conclusions of this analysis might
be weakened or even reversed in the future.
Back.

SOX remains one of the few open source-published strong-crypto
payments systems available.
Back.

Support
For those hoping for a more economic model, the cost of trading is thus:

profit = n * x(p) - n * p(s) * c(s)

assuming zero profits we can drop the number of transactions term, n,
and the cost per transaction function, x(p), can be shown to
be simply a function of the probability of support, p(s), and
the cost of each support call, c(s) :

x(p) = p(s) * c(s)
= cost per support call / number of transactions per support call

In other words, drive down the support call frequency and cost.
Of course, this assumes away development as sunk costs, and ignores
marketing.
Back.

Hardware
For those interested in details, all servers ran on
a single Pentium 100 MHz machine running Unix.
Single payments complete within about 5 seconds,
and trades are settled within about 20 seconds.
Back